2Mercury Athletic FootwearOverview of Active Gear:Active Gear is a relatively small athletic and casual footwear company$470.3 million of revenue and $60.4 million of EBIT compared to typical competitors that sold well over a $1.0 billion annuallyCompany executives felt its small size was becoming more of a disadvantage due to consolidation among Chinese contract manufacturersJoel L. Heilprin

4Mercury Athletic FootwearOverview of Active Gear:Company strengths:By focusing on a portfolio of classic brands, Active Gear has been able to lengthen its product lifecycleIn turn, this has led to less operating volatility and better supply chain management as well as lower DSICompany weaknesses:By avoiding the chase for the latest fashion trend and avoiding big box retailers, the company has had very low growthJoel L. Heilprin

5Mercury Athletic FootwearOverview of Mercury Athletic:Mercury was a subsidiary of a large apparel companyAs a result of a strategic realignment, the division was considered to be non-core2006 revenue and EBITDA were $431.1 million and $51.8 million respectivelyUnder the egis of WCF, Mercury’s performance was mixedWCF was able to expand sales of footwear, but was never able to establish the hoped for apparel lineJoel L. Heilprin

6Mercury Athletic FootwearOverview of Mercury Athletic:Products:Men’s and women’s athletic and casual footwearMost products were priced in the mid-rangeMore contemporary fashion orientationCustomers:Typical customers were in the age rangePrimarily associated with X-games enthusiasts and youth cultureDistribution:Products were sold primarily through a wide range of retail, department, and specialty stores – including discount retailersJoel L. Heilprin

7Mercury Athletic FootwearOverview of Mercury Athletic:Company strengths:Established brand and identity within a well defined niche market that seems to be growingStrong top-line growth resulting from inroads with major retailersProducts were less complex; and therefore, cheaper to produceCompany weaknesses:Increased sales came as a result of pricing concessions to large retailersProliferation of brands led to decreased operating efficiency and a longer DSIWomen’s casual footwear was a disasterJoel L. Heilprin

8Mercury Athletic FootwearStrategic Considerations:Central Question: What Are the Likely Rationales for a Combination of Active Gear and Mercury?How do the acquirer and target fit together?What are the potential sources of value?How would any potential sources of value be realized?Joel L. Heilprin

9Mercury Athletic FootwearStrategic Considerations:Potential sources of value creation:Operating synergies coming from economies of scale with respect to contract manufacturersPerhaps some economies of scope with respect to distribution – extending the distribution networkPossible combination of the women’s casual linesJoel L. Heilprin

11Mercury Athletic FootwearTV is the going concern value at the end of the explicit forecast periodExplicit forecast period is based on the analyst’s judgmentFirm Value & Cash Flows:As a starting point, let’s start with a basic valuation paradigmNote that the sole determinant of value is the generation of cash flowFurther the only relevant factors are the amounts, timing and risks of the cash flowsFCF is assumed to be the mean of an a random distributionAnnual ForecastsTerminal ValueJoel L. Heilprin

12Mercury Athletic FootwearNOPATNet reinvestmentFirm Value & Cash Flows:Determination of FCFTo begin, the preceding equation led to a value of the entire enterprise, meaning V = D + EThus, we are interested in what the total business is worth irrespective of who gets the cash or how it’s financedIn turn, this means we are interested in the un-levered FCFUn-Levered FCF = EBIT(1-t) + Depr’ - ∆WC – Cap-xJoel L. Heilprin

13Mercury Athletic FootwearFirm Value & Cash Flows:Determination of FCFIn case Exhibit 6, Liedtke provides a set of projections for each of the operating segments – Thus,Multiplying EBIT by (1-t) yieldsthe first term in the FCF equationQuestion: Are taxes being overstated?It is true that interest expense creates a tax shieldHowever, the value of the tax shield is acknowledged in the WACC or in a separate calculation when using APVConsolidated Segment RevenueLess: Segment Operating ExpensesLess: Corporate OverheadOperating Income = EBITJoel L. Heilprin

14Mercury Athletic FootwearFirm Value & Cash Flows:Determination of FCFHaving calculated NOPAT, we should have the following results, and are now in a position to proceed to the next step in FCF determinationNote that the administrative charge has not been included in operating expensesThis is because the new owner would not incur the cost, and you’ll note that its not included in Liedtke’s projectionTo move from NOPAT to FCF we will simply subtract all of the net reinvestment in the firm’s operationsThis is the same as subtracting the ΔNOA; or in our case, (Cap-x + Depr’ – ΔWC)Joel L. Heilprin

15Mercury Athletic FootwearNote that cash for larger firms with access to capital markets may not be part of working capitalMercury Athletic FootwearNet Fixed AssetsFirm Value & Cash Flows:Determining FCF - ∆WCBy reorganizing the balance sheet as shown, the net operating assets and liabilities can be quickly segregatedBased on Exhibit 7, the working capital assets are cash, accounts receivable, inventory, prepaid expensesThe WC liabilities are accounts payable and accrued expensesOf course, the same excise can be used to determine the net investment in fixed assets (cap-x – Depreciation)Joel L. Heilprin

16Mercury Athletic FootwearFirm Valuation & Cash Flows:Determining FCF – final thoughtsBased on the preceding exercise involving the reorganized balance sheet, we can see that the DCF methodology is aimed at valuing the operations of the firm (left side of B/S)Further, we can seeFCF = EBIT(1-t) - ∆WC - ∆Net Fixed AssetsBy forcing every line item to be placed in one of the B/S “buckets”, we ensure that ALL of the changes in operating assets & liabilities are reflected in FCFNot just those included in working capital, cap-x or depreciationJoel L. Heilprin

17Mercury Athletic FootwearLiedtke’s Projections:Using the information contained in Exhibit 6, the following set of FCF projections can be developed:Are Liedtke’s projections reasonable?Consider the revenue growth rates & operating marginsWhat about the changes in working capital?Joel L. Heilprin

18Mercury Athletic FootwearLiedtke’s Projections:To begin with, the EBIT margins are highly simplified – though not unreasonableThere is a tapering off of growth in athletic shoesMen’s casual is assumed to grow at what might be the long-term rate of the industryWomen’s casual is to be discontinuedThe relatively high growth rates in athletic shoes for the early years are presumably a result of continued expansion into large discount retailersJoel L. Heilprin

19Mercury Athletic FootwearLiedtke’s Projections:Changes in net working capitalNotice that the increase in 2008 is smaller than that of 2007, and that the rate of ∆ increases again in 2009 and falls inLiedtke has based his WC projections on historical cash cycle ratiosThe volatility is the result of discontinuing the women’s casual line along with a lagging effect from changes in revenue growthJoel L. Heilprin

20Mercury Athletic FootwearCost of Capital:Exhibit 3, provides some comparable company information that includes observed equity betas along with the market values for debt and equityUsing that information each comparable firm’s asset beta can be obtained using one of the followingβasset = (E/V)βequity or βasset = (E/(E + net Debt(1-t)))βequityAssumes a constant D/V ratio and a βdebt of zeroAssumes a changing capital structure with a βdebt of zeroJoel L. Heilprin

21Mercury Athletic FootwearCost of Capital:Based on the preceding, the following average un-levered beta can be obtainedA constant capital structure was used based on Liedtke’s choice of a WACC based on a 20% D/V ratioIf a changing capital structure had been assumed, the un-levered beta would have been 1.37Joel L. Heilprin

23Mercury Athletic FootwearTerminal Value:If Mercury has indeed reached a steady state by 2011, then we can envision the firm as providing a stream of cash flows that grows at a constant rate foreverThis would imply that the going concern could be valued as a growth perpetuityPV2011 = (FCF2011)(1+g)/(r – g)Given that we have already developed estimates for FCF and WACC, an estimate of the long-term growth rate needs to be calculatedJoel L. Heilprin

24Mercury Athletic FootwearTerminal Value:Estimating the long term growth rateAs a starting point, no business can grow faster than the macro economy on a continuous basisThus, an upper-bound equal to the long-run macro economic growth rate must existIn terms of lower bounds, the long-term growth rate must be positive or else the firm would not be a going concern (i.e. it would have a finite life)A growth rate equal to the long-run rate of inflation would suggest a zero real growth rateIn the case of Mercury, this would seem to be the lower boundJoel L. Heilprin

27Mercury Athletic FootwearCompleted Valuation:Below is a completed valuation of Mercury based on a WACC of 11.06% and a long run growth rate of 2.78%Firm value is equal to the value of the operations plus the value of net non-operating assets (i.e excess cash)Joel L. Heilprin

28Mercury Athletic FootwearCompleted Valuation:The table below shows the sensitivity to growth rates and discount ratesNote the extreme variance of results even if the range is tightened to a growth rate of 2.78% - 4% and a discount rate from 10% - 12%Joel L. Heilprin